When considering dividend yields, UK investors tend to get wary around the 7% mark. This is often thought of as an area where the sustainability of payments is questionable. If a company is allocating too much cash to dividends it can lead to operational issues and weaker performance.
At that point, dividends are usually cut, leaving shareholders disgruntled. This in turn dissuades new investment, leading to a downward spiral.
There is the occasional exception to the rule but it’s considered a good estimate to go on with.
Passive income stocks: our picks
Do you like the idea of dividend income?
The prospect of investing in a company just once, then sitting back and watching as it potentially pays a dividend out over and over?
If you’re excited by the thought of regular passive income payments, as well as the potential for significant growth on your initial investment…
Then we think you’ll want to see this report inside Motley Fool Share Advisor — ‘5 Essential Stocks For Passive Income Seekers’.
What’s more, today we’re giving away one of these stock picks, absolutely free!
With that in mind, I prefer to aim for an average yield of around 6% to stay on the safe side. Yields in such a portfolio may occasionally stray above 7% but generally level out.
Look beyond the yield
Even a yield below 7% doesn’t guarantee anything as the company may still struggle to cover payments. To truly assess the sustainability of payments, it helps to check debt and free cash flow.
Companies spend their free cash in different ways. It can be saved up, used to reduce debt, spent on share buybacks, or used to pay dividends.
Debt isn’t a problem so long as interest payments are covered. If not, dividends could face the chopping block. But with cash flowing and debt well covered, there’d be little reason to cut dividends.
Don’t forget to diversify
Businesses in similar industries tend to have similar financials. So when looking for sustainable yields, an investor may end up picking four insurance companies. Sure, they may all be reliable dividend payers but the portfolio would be too exposed to one sector.
It would be better to pick the most reliable high-yield dividend stock from four different industries. Diversification is all about balance.
Two examples
Consider National Grid and ITV (LSE: ITV). They operate in different sectors with consistently high yields and dividend coverage ratios above two.
As the UK’s main gas and electricity supplier, National Grid is a company that enjoys consistent demand and stable revenue. Its operations are well regulated, so it tends to be quite stable, with annual dividends increasing consistently for over 20 years.
But it faces pressure from energy price caps and costly upgrades to meet decarbonisation goals. This has resulted in growing debt, a problem compounded by rising interest rates. With cash flow dwindling, it recently cut dividends by 15%.
ITV, on the other hand, has enjoyed growing equity while reducing its debt lately. It lacks the solid payment track record of National Grid but enjoys steady cash flow. This lessens the chance of dividend cuts, making the 7% yield attractive.
Competition is fierce, though, with the likes of Netflix, Disney, and Amazon muscling in on the digital streaming market. While ITV continues to extract decent value from its Studios arm, profits are at risk from losses in streaming.
This partially contributed to a minor revenue decline in 2023, from £3.73bn to 3.62bn. But its first-half 2024 results show some recovery, with revenue up 2.4% and profit margins soaring to 17% from 2.6% a year earlier.
These examples show how dividend stocks can differ, yet both remain popular options and worth considering as part of an income portfolio.
